You’re in an emerging area of finance and law in which lenders make loans to GPs backed by LP commitments. How is the market developing?
We hosted 70 attendees at an event on the topic a few years ago. In March, we took part in the annual Fund Finance Association Symposium with 600 clients including banks, private equity funds, investors, service providers and lawyers and placement agents. The Fund Finance Association is holding its second annual European symposium in October.
What’s the universe of lenders and total leverage look like for these credit facilities?
Mayer Brown has been doing this for 15 or 20 years. There are roughly 50 banks in the space, with 10 to 15 of them that regularly lead fund financings. It’s a big business and it’s growing. Citing Preqin data, there’s about $1.2 trillion to $1.3 trillion in private equity dry powder. Maybe about $300 billion of subscription facility lender commitments are out there. Generally, the global advance rate is about 20 to 25 percent of total dry powder, so there’s a lot that’s not been leveraged.
Do these credit facilities unfairly hike fund IRRs?
Clearly it can boost IRRs, but there is nothing unfair about it. IRRs can be boosted by several percentage points in a number of ways. For one, leverage on a fund allows you to invest in more assets, which can amplify returns. Interest on fund leverage is often much more inexpensive than asset-level leverage as banks are at least in part looking at the credit quality of fund investors rather than simply a single asset of the fund. That debt-service savings translates to higher IRRs. If LPs are concerned about the use of fund-level leverage, they’re able to negotiate for debt-percentage limits and/or time horizons on the length of time a fund-level draw can be outstanding.
How do these loans speed up transactions?
Under governance rules in most private equity funds, it takes 12 to 15 days to get the money for capital calls, but by the time it happens, it may take 16 or 17 business days. You may not have that long to get the money if you want to buy a commercial building in New York City, for example. If you’re a banker putting together a deal, you’ll feel comfortable if you have a lender saying Fund X has a line of credit with same-day borrowing available.
How is risk to the lenders or GPs handled?
There’s often a threshold of about 10 to 20 percent of investors in a fund not meeting a capital call. That’s a signal to the banks that something is wrong. That triggers a default and the lender can put on the GP’s shoes and call the capital. In most private equity funds, the GP can issue a capital call from non-defaulting partners to make up for a defaulting partner. That’s the same with or without a line of credit. No subscription facility has been unpaid, even during the financial crisis. With case law such as the lawsuit Chase Manhattan Bank v. Iridium Africa Corp, which involved unpaid capital calls, the law is clear that investors are on the hook and that commitments are enforceable.
The GP wants to be careful about any default. It doesn’t want the bank coming in and calling up on its investors. If your Fund II facility goes into default, it’ll be hard to raise Fund IV.
Action Item: Fund Finance Association: http://www.fundfinanceassociation.com/
Photo of Zachary Barnett courtesy of Mayer Brown